Question

Suppose you are the Chief Financial Officer of a tech company and that you want to obtain a good estimate for the cost of capital of a new investment project. Your project is an investment in a new production line for semi-conductors and has an expected lifetime of 20 years. That is, you expect to receive cash flows from the project for 20 years.

Explain how you would obtain a good cost of capital estimate for your project using two different methods (Benchmarking & CAPM). You should illustrate how you would calculate the cost of capital using a fictitious example in which you may use information from the textbook and course slides. Make sure you justify any numbers you use in your example and discuss any advantages and disadvantages of using one method versus the other.

Answer 1

What is Cost of Capital:

The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used. Many companies use a combination of debt and equity to finance their businesses

Cost of capital is the required return necessary to make a capital budgeting of the project, such as building a new factory, worthwhile. The combination of equity and debt are generally called weighted average cost of capital .

Capital Asset Pricing Model: (CAPM)

The capital asset model is the most widely used method determining cost of capital. The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

This based on the following principle

• Equity share holders have to be paid the minimum risk free return and risk premium
• The risk free rate of return represents the rate of interest of govt securities.

Benchmarking method:

The benchmarking method is about comparing the cost of capital of similar industry or comparing the past practices of the same company. Under this method companies of similar nature and with same borrowing methods are compared to analyse which companies cost of capital are better. If the company is investing its money for further expansion, the cost of capital of initial investment made can be compared.

Example

The risk free rate of return for an economy is 8%. The expected return from equity market is 18%. The Beta of ABC company 1.2. What its cost of equity under CAPM Method.

Cost of Equity = R1+ beta(Rm-Ri)

=8%+1.2(18%-8%)

= 8%+ 1.2(10%)

Cost of Equity under CAPM =20%

Benchmarking: Suppose for a similar industry which is involved in same production process and if its cost of capital is 18%. Then the company should look to change the borrowing method to reduce its cost of capital.

Advantages of CAPM:

1. CAPM is simple to calculate and its being universally used method to identify the cost of capital

2. When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations, like the weighted average cost of capital (WACC), cannot be used. However, the CAPM can be used.

Disadvantages of CAPM:

1. The risk free return is not percentage is not constant and returns will change for each day.
2. Businesses that use the CAPM to assess an investment need to find a beta reflective of the project or investment Often, a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome.

Benchmarking method advantage

1. Benchmarking with competitor industry will help the company identify the gaps and equip itself better.
2. To stay competitive and earn better margins.

Benchmarking method disadvantage

1. Details are most derived from external source, which may not be accurate. Working with inaccurate data will lead to wrong conclusions.
2. Need to make lot of assumptions, since many data are internal to the company which will not be revealed by the management.